Credit Ratings Depend on Size

This column was originally published on RealMoney on Dec. 26 at 2:55 p.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

If you find a little extra time this holiday week, seek out some self-congratulatory economic literature from the 1990s boom discussing why the U.S. was a special place to start and nurture new businesses.

No, this is not another tendentious screed on Sarbanes-Oxley; please keep reading.

The list always included American firms' direct access to capital markets; this stood in stark contrast to both Japan and Continental Europe, where commercial banks acted as gatekeepers to credit. Commercial bankers may be fine people on all counts, but their primary functions are lending money and providing services, not engaging in venture capital. The old joke about bankers only lending money to those who can prove they do not need it has a good measure of truth.

Capital markets come in three flavors: debt, equity and hybrids thereof, such as convertible bonds. If we may generalize, start-up ventures should prefer issuing debt, as opposed to equity, if they are confident about their prospects. Counterbalancing this desire is a simple reality: Younger and smaller firms, even those destined to succeed, may appear less creditworthy than their older and larger cousins. Venture capitalists exist to take a risk in exchange for an equity stake in such firms.

Given this background, we should expect to see significant differences between the credit ratings of firms as a function of their size. And as different industries have different credit demands, we can extend the analysis to each of the 10 economic sectors defined by Standard & Poor's -- a topic last visited in the context of sector-specific credit default swap costs in June.

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